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How to document transfer pricing to stay on the right side of taxing authorities

The IRS is beefing up its scrutiny of transfer pricing and, if your company isn't documenting its practices in selling goods and services across divisions or subsidiaries, it could face substantial penalties, says Dick Lam, director of Transfer Pricing at Burr Pilger Mayer.

“The IRS has determined that, either inadvertently or by design, many companies have not been properly reporting transfer pricing,” says Lam. “Compliance has always been required, but with the hiring of 600 to 800 additional examiners at the IRS, there will be a heightened emphasis.” Smart Business spoke with Lam about how to handle transfer pricing to stay on the right side of taxing authorities.

What is transfer pricing?
A transfer price is an internal price determined by a business for the transfer of goods, services or other products between divisions or units. Because it is an internal price, it is generally not control directly by market forces.

The most obvious example is the transfer of tangible goods between a manufacturer and a related distribution company, but transfer pricing also applies to services. For example, if a parent company sends a manager overseas to set up a plant, the value of those services must be charged to that foreign entity. Likewise, if you’re advancing funds, there needs to be interest charged on most loans and advances.

The most difficult transactions to evaluate relate to intellectual property, such as the use of the parent company’s trademark overseas or industrial processes and formulas developed in the U.S. Intercompany charges for intellectual property are frequently overlooked, but the IRS is looking to recover the cost of developing those intangibles and expects the U.S. party to receive fair compensation for the use of that property overseas.

When both divisions or units operate and are taxable in the U.S., there is not generally much tax impact on which entity reports the revenue. Internationally, however, there can be large differences in tax rates and both countries involved want to make sure they’re getting their fair share of tax revenue.

How can companies determine a fair transfer price?
Following the arm’s length standard, companies are supposed to create a price that represents the price that would have been negotiated had those two units been dealing with each other as if they were unrelated. That is obviously an artificial construct, because they can never be truly at arm’s length, but they can look at indicators in the marketplace as to what the price of that good or service should be.

How do the U.S. and other countries protect against abuses?
If companies are crossing international borders, the tax rate can be significantly different in each jurisdiction. Each country’s tax revenue is directly impacted by that transfer price and each wants to make sure it gets its fair share. In other instances, the tax rates may be similar, and the taxpayer is merely a stakeholder as the two countries fight it out to determine whether the price is right.

In the U.S., there is no requirement for documentation to be submitted with tax returns, but to avoid penalties, should the company get it wrong, it is required to compile contemporaneous documentation that involves an economic study to analyze the functions, risks and assets performed by each party involved in that transaction. The study applies economic principles to the analysis to come up with a conclusion that the transfer prices assigned by the company are consistent with the arm’s length standard.

If the company fails to prepare that document and the IRS determines on audit that the price is substantially different than the arm's length price, penalties can be 20 or 40 percent of the tax involved. Other countries, however, such as China, require that certain documents be included with tax returns to substantiate the prices that are being charged.

The IRS has issued new regulations and proposed new tax return disclosure schedules. Effective for 2010, large corporate taxpayers will be required to file a schedule of uncertain tax positions, which would include uncertain results for transfer pricing. Disclosure requirements will be phased in for smaller corporate taxpayers over the next five years.

How can a company get started with compliance?
If you haven’t been doing it correctly for years, there are open years exposed to adjustment by tax authorities. The place to start is to get it right going forward with the most recent year’s tax return.

Most importantly, review and document transactions in advance. Create inter-company agreements. If there is use of intangible property overseas, such as a trademark or process intangible, create a license agreement. That elevates awareness within the company and also helps convince the rel-evant tax authority that the company has thought about this in a responsible manner. That agreement should establish all the terms for the payment for the use of the covered intangible. Documentation of those transactions should also include the rationale for how the prices were determined.

How do outside advisors assist companies to comply?
A third party expert can assist the taxpayer in preparing a functional analysis by asking the right questions about what assets, services and people are involved in providing essen¬tial functions for the business and evaluating what an arm’s length return should be.

In addition, an adviser may be able to identify situations in which a company is reporting too much profit, or suggest ways to alter operations to get better results. There is an upside to planning and there are opportunities to use transfer pricing to improve the bottom line for some companies.

This publication contains information in summary form and is intended for general guidance only. It is not intended to be a substitute for detailed research nor the exercise of professional judgment. Neither BPM nor any member of the BPM firm can accept any responsibility for loss brought to any person acting or refraining from action as a result of any material in this publication. On any specific matter, reference should be made to the appropriate advisor.